Options Trading Strategies: Leveraging Volatility
By: Steve Smith
Spread your wings with a butterfly strategy as a low risk way to earn big profits. Options trading strategies like this play give you a wide range to realize large gains.
Making trades based on an earnings report poses several challenges, but can deliver big rewards as the reports tend to cause large price moves. For the best options trading strategies, not only does one need to accurately predict what the company’s actual results will be, but how these compare to analyst estimates. Then you must determine how investors will react. Has the stock run up ahead of the report and therefore become vulnerable to a “sell the news reaction?”
One way reduce the risk, and hopefully boost the rewards, is to use options. But this means layering in what the options are already “pricing in” via their premiums. The premiums or price of the options are determined by their implied volatility. Implied volatility typically increases prior to the earnings report in anticipation of the market moving news, and then declines rapidly immediately following the release regardless of the price movement.
I refer to this as the Post-Earnings Premium Crush, or PEPC. PEPC can drive even experienced traders crazy and often leaves novices with unexpected losses. For example; often times someone will buy straight up calls expecting a stock to rally following a the earnings report. The results are better than expected and the shares do indeed move. But the value of the call options actually declines! How can this be?
The options might have been pricing in a 5% price move but the stock might have only moved 3% and the resulting decline in implied volatility or PEPC offsets the value increase of the underlying shares, or delta impact, leaving the option’s call value little changed or even down.
This phenomena of pattern of spike then retreat in the implied volatility each quarter can clearly be seen in Google:
As you can see, implied volatility has been climbing as the stock approaches its earnings this Thursday, January 29th.
The Butterfly Effect
All of this is a big wind up to introducing an options strategy that not only eliminates the negative impact of PEPC, but actually uses it to its benefit. I call it the butterfly spread.
A butterfly is a 3-strike position that involves a combination of the following:
-The sale (or purchase) of 2 identical options
-The purchase (or sale) of 1 option with an immediately higher strike than the 2 identical
-The purchase (or sale) of 1 option with an immediately lower strike than the 2 identical
All options must have the same underlying stock, and have the same expiration date. One way to think of butterflies is as a combination of 2 vertical spreads — one bullish and one bearish — with a common middle strike. It has a 1 x 2 x 1 construction.
In the long butterfly, in which the two outside strikes are purchased and the “body”, or center strike, is sold for a net debit. This “stack of spreads” (one long, one short) creates a position that is initially both near delta and theta neutral and changes in implied volatility, have little impact on the value of the position. In fact, the high implied volatility or pumped up premiums allow you to establish these positions for a very low cost.
The maximum profit is achieved if shares are at the middle, or short, strike price at expiration as all option move to their intrinsic values. With the use of weekly options we can use a butterfly to create a position with a very attractive risk/reward in which the profits are literally realized overnight.
Google Going Down
Today, we’ll focus on how to use a butterfly spread to profit in Google following its earnings report after the close on Thursday, Oct. 26th.
With Google currently trading around $992, the options are currently pricing in about a 4% or approximately $40 price move. Given stock has had difficulty breaking above the recent highs at $1020 and growing concerns over effectiveness of online ad spending and potential for continued fines and litigation over monopolistic behavior, I want to target a move to the downside for a “sell the news” response to the report.
I’m taking the $40 move being priced in and targeting the $955 level which also represents major support on the chart.
I’m using the weekly put options that expire this Friday, Oct. 27, the day after the earnings report.
-Buy 1 Oct. 990 put for $18 per contract
-Sell 2 Oct. 955 puts for $6.50 a contract
-Buy 1 Oct. 920 put $1.00 a contract
This is a $6 net debit (The cost of the two puts purchased$18 + $1 = $16 minus the premium collected of the two puts sold 2 X $6.50 = $7).
This $6 cost is the maximum loss and would be incurred if shares of Google are above $990 or below $920 on Friday’s expiration.
Here is what the risk/reward graph profile looks like:
The maximum profit is $29 (calculated by the width between strikes minus the cost or $35 – $6 = $29) and would be realized if GOOG is exactly at $955 on expiration.
For each 1x2x1 spread you are risking just $600 for a potential $2,900 profit. That’s over a 4:1 risk/reward, or a potential 400%.
Lesser profits can also be realized if shares are anywhere between $926 and $984, a nice wide 5.8% range, on expiration.
This is how a butterfly can turn into a beautiful earnings play.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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